On March 27, we lost Daniel Kahneman, a giant in the world of personal finance. Kahneman was not a financier, tax advisor, or estate planning attorney. He was a trained psychologist and, fun fact, the nephew of Rabbi Yosef Shlomo Kahaneman, the former head of the Ponevezh Yeshiva. Yet his impact on the world of wealth management was vast. He was a pioneer in the field of behavioral economics and was awarded the 2002 Nobel Memorial Prize in Economic Sciences shared with Vernon L. Smith for his work in this area.
Given his innovative work, Kahneman was once asked if he would accept the informal title of “father” of behavioral economics. He pointed to the University of Chicago economist Richard H. Thaler and his colleague and partner on many projects, Amos Tversky, as the fathers of the field. He agreed to accept the title of “grandfather” of behavioral economics.
In short, behavioral economics is the study of psychology as it relates to the economic decision-making processes. It explores why people oftentimes make irrational decisions and why human behavior does not follow the predictions of economic models.
In my own practice, I find myself discussing the implications of behavioral economics for investing far more than most other topics. After all, the biggest stumbling block for many investors is themselves. The tendency for people to get in their own way is usually what prevents folks from achieving success in the markets.
Below is a shortlist of examples of the intersection of psychology and investing where Kahneman made contributions. Each of them comes up regularly in my conversations with clients.
Anchoring-and-adjusting: An individual’s decisions are influenced by a reference point, or “anchor,” which can be completely irrelevant. Anchoring can be used to advantage in sales and price negotiations where setting an initial anchor can influence subsequent negotiations in your favor. However, it can cause erroneous results when the initial anchor deviates from the true value.
For example, if your friend in shul told you that a certain stock is worth no more than $20 that can become your anchor for its value. If it is now trading at $30, you may be reluctant to buy the stock, even if it’s a sensible addition to your portfolio. You may also assume that if it drops to $10 it is a good buy because you are anchored to that $20 price. Meanwhile, your friend’s assumptions and analysis (or lack thereof) may not be based on anything other than his own uninformed opinion. Yet you now will make decisions based on the price he mentioned.
Availability heuristic: This is a type of cognitive bias that helps us make fast, but sometimes incorrect, assessments. It involves relying on information that comes to mind quickly or is most readily available to us. For example, an investor may impulsively invest in a real estate project because they saw a news story about how the returns for real estate have been excellent over the past few years. However, making an investment decision based on recent news headlines without conducting a thorough analysis is ill-advised. It leads to impulsive investment decisions based on readily available, but potentially biased, information.
Base rate fallacy: This is also known as “base rate neglect” and is a cognitive error of prioritizing a particular set of data over the general information of a larger collection of data (i.e. the “base rate”). This results in an error of judgment.
For instance, an investor has two investment opportunities. One investment has excellent recent returns but is incredibly risky and has a long history of eroding investors’ wealth. The second investment has had lackluster recent performance, but over the long term provides more consistent returns with a lower probability of losses. Investors may be more likely to choose the first riskier option that has experienced better returns as of late. This may be done if they are not given sufficient information about their historical performance. This is a tactic used by promoters or marketers of certain investments, where they will highlight excellent returns over the past year or two while conveniently neglecting to mention historical returns in that asset class. This could lead to devastating outcomes for investors.
Loss aversion: This is a phenomenon where a real or potential loss is perceived by individuals as psychologically or emotionally more severe than an equivalent gain. For example, the pain of losing $100 is often far greater than the joy gained in finding the same amount.
This is something that comes up often when working with an individual who has massive gains in their portfolio. They may have gained hundreds of thousands of dollars in their account, yet a relatively small drop in value can throw them into an anxious tizzy or even cause them to sell their investments and abandon their strategy.
Optimism bias: This is the tendency to overestimate the likelihood of positive events and underestimate the likelihood of negative events. Optimism bias causes most people to expect that things will work out positively, even if rationality suggests that problems are inevitable.
I have seen this bias present itself in two ways. The first is when clients insist on concentrating in a certain area of the market. Some people have told me that “real estate only goes up” or “tech stocks are the future, why invest anywhere else?” The truth is no investment or area of the market is impervious to a downturn. This is why it’s essential to maintain a diversified portfolio regardless of how much you believe in any one particular investment. The second area is insurance planning. While it’s good to be optimistic about investing and life, bad things do happen. Death, disability, and long-term-care issues face all families. This is why buying insurance to protect against these unavoidable circumstances is essential to any plan. While it’s good to be optimistic, it’s even more important to be realistic in your strategy.
Status quo bias: This is the tendency for people to stay with what’s familiar and comfortable rather than change and take risks. In the context of investing, this can be dangerous as it can lead to missed opportunities or staying on a path that will lead to financial challenges down the road.
I see this bias come up frequently with clients on the cusp of retirement. They have accumulated accounts at various firms, old employers, and an assortment of other random investments. The default position is to leave things where they are. They often search for excuses to maintain the status quo, citing good returns (which usually isn’t true), a nice employee of the bank (which is not relevant), or the perceived advantage of having money spread across many institutions (there isn’t one). For many investors, overcoming that urge to do nothing by cleaning up and consolidating their investments is an essential step to having financial peace of mind in retirement. As I am fond of reminding my clients “Indecision is still a decision and it’s usually the wrong one.”
There is a myriad of other biases that impact our personal finances. It’s worth discussing this topic with your financial advisor, as well as the best ways to overcome them. Too often the focus of a financial strategy is on finding the investment with the highest possible return, mitigating taxes, and lowering fees. In reality, spending more time on controlling our behavior and refining our process around money can make us all more successful investors. Understanding Professor Kahneman’s groundbreaking work in this field is an essential first step to any sound investment strategy.
May his neshama have an aliyah!
